Analyzing RBI’s instruments for “Liquidity Management”

Among the points of contention between RBI and the government is market liquidity condition. While RBI says that there is enough liquidity in the market, government is not sure of that. Both have a point there. But how exactly does RBI manage liquidity and how is it different from managing money supply through monetary policy. Here is an attempt to understand RBI’s liquidity management operations.

Basic difference between monetary policy and liquidity management is that former takes a longer term view of the economy and sets the interest rate so as to achieve the desired level of money in the market. However, within this broad objective, there are significant volatility on day to day basis. For instance, banks need more money towards the end of the month, when companies make payment towards their advance taxes or say, during festival season when there could be more withdrawal from retail accounts. This is corroborated by actual figures. As per RBI data, banks’ advances to the commercial sector rose by as much as Rs 1.8 lakh crore during 14th – 28th Sept (most likely to pay their tax dues to the government). Similarly, banks’ advances to government increased by Rs 47,000 crore between 28th Sept and 12th Oct (which fell by Rs 60,000 crore in the next fortnight).

Banks do not have that much surplus cash in its books to manage such outgo and RBI has to come to the rescue as banker to the banks. (Total cash balance with banks stand close to Rs 80,000 crore which is distributed across all its branches, average cash being about Rs 60 lakh). Not only sudden withdrawal, banking system can even face sudden increase in supply which needs to be absorbed by RBI to maintain stability and avert risk of spurt in inflation. These short term movements are not only unpredictable but cannot be managed by the monetary policy instruments such as interest rate or even by SLR or CRR. On the contrary, use of these instruments for short term management can create even bigger volatility and scramble for cash.

So, how does RBI manage it? The most commonly used instrument is repo and reverse repo auction. Repo auction refers to sale of government bonds by banks which are purchased by RBI, thereby providing liquidity to the system. (It may be noted here that most of the liquidity operations involve use of government bonds as collateral). Reverse repo is when banks have excess cash and do not any avenue to deploy it. In such a scenario, they can purchase government securities from RBI. The rate of interest paid/received is what is set during the monetary policy. The current repo rate is 6.5% and reverse repo rate (interest paid by RBI) is 6.25%. Repo and reverse repo have another variant called variable rate auction where obviously, the rates are decided by the market depending upon the liquidity conditions. These four together form RBI’s Liquidity adjustment facility (LAF) tools. During the month of Sept, RBI injected Rs 3.9 lakh crore through repo and absorbed Rs 9.5 lakh crore through reverse repo (including variable, in both cases). (This broadly means market had excess liquidity during the month and RBI is right with regard to the market liquidity conditions).

However, as per the rules, RBI can absorb/inject money through LAF only up to a limit and has to use other instruments beyond that. The other tools available with RBI are Marginal standing facility (MSF), Standing liquidity facility (SLF), Market Stabilization Scheme (MSS) and Open market operations (OMO). MSF is next most used option where the interest rate is 0.25% higher than repo rate. During the month of Sept’18, RBI injected liquidity to the extent of about Rs 48,000 crore in the market, still, much less than the amount transacted through LAF. SLF is another instrument to inject liquidity, the important factor being that even primary dealers can secure money from RBI through this route. However, this is not a widely used instrument.

MSS is an interesting instrument, introduced in 2004 to absorb the huge liquidity caused due to surge in inflow of foreign exchange. This is different from other instruments since bonds under this are issued by RBI and the money so absorbed is not used by the government for its expenditure. MSS came in handy during the emergency situation after demonetization when RBI ran out of government bonds to absorb the excess liquidity! The situation was resolved by increasing the limit of purchase through MSS from Rs 30,000 crore to Rs 6 lakh crore. However, MSS is also not a widely used instrument since the liability of interest payment against this falls on RBI.

The next and the last resort is open market operations (OMO) which looks akin to declaring an all out war! When everything else fails to bring stability in the market, RBI decides to go for OMO. While all the tools referred earlier involved sale/purchase of bonds to be purchased/sold back later, OMO is permanent sale/purchase of bonds and in a way, links the short term market to the longer term monetary policy objective. RBI sold bonds worth Rs 68,000 crore through OMO during 12 months ending June’18 to reduce the liquidity. However, the policy has been reversed with purchase of bonds worth Rs 20,000 crore during Sept’18 and continued purchases subsequently to improve liquidity and manage market sentiments, a fall out of IL&FS default.

Despite so much of efforts from RBI, market remains unsatiated! When RBI is not available, financial institutions help each other meet their needs in a market called “Money Market”.

Author – Ashish Agrawal

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